Inflation and Deflation

Inflation A persistent increase in the average price level in the economy, usually measured through consumer price index (CPI) Governments desire a low and stable rate of inflation Costs of inflation Loss of purchasing power o If the rate of inflation is 2% the average price of all goods has risen by 2% o If income remains constant then youre not able to buy as many goods and services as before the increase in the average price level = fall in real income o If income is linked to the inflation rate then you will not face a fall In your real income Effect on savings o If the annual interest at the bank is lower than inflation then the savings will not be able to buy as much loss in purchasing power o Inflation discourages savings o May choose to buy fixed assets there are fewer savings available in the economy for investment purposes negative implications for economic growth Effects on interest rates o Commercial banks make their money from charging interest to people who borrow money from them o If there is a high rate of inflation, then banks raise their nominal interest rates in order to keep the real rate that they earn positive Effect on international competitiveness o If high rate of inflation exports become less competitive o May lead to fewer export revenues and greater expenditure on imports worsening the trade balance o Might lead to unemployment in export industries and in industries that compete with imports Uncertainty o Reduced investment due to a fall in the availability of savings/higher nominal interest rates o Firms may be discouraged from investing due to the uncertainty associated with inflation negative implications for economic growth Labour unrest o If workers do not feel that their wages and salaries are keeping up with inflation o Disputes between unions and management

Deflation A persistent fall in the average level of prices in the economy Disinflation: the falling rate of inflation Good deflation o Improvements in supply side economy and/or increased productivity o AD/AS diagram an increase in the long-run AS curve can result in an increase in real output and a fall in the price level (deflation) o Real output increases lower level of unemployment o Positive An increase in real output and a fall in unemployment Bad deflation o Due to the demand side of the economy o AD/AS diagram a fall in AD results in a decrease in the price level and a decrease in real output o Unemployment will rise due to less demand o Negative because it results in a fall in real output and a rise in unemployment Costs of deflation Unemployment o AD is low businesses are likely to lay off workers o May then lead to a deflationary spiral - If prices are falling consumers will put off the purchase of any durable goods (wait until prices drop further) (deferred consumption) reduce AD o Consumer confidence will fall o Low consumer confidence further depress AD Effect of investment o Businesses make less profit/losses unemployment o Low business confidence reduced investment o Negative implications for future economic growth Costs to debtors o People who have a loan value of their debt rises o If low profits it is harder for businesses to pay back the debt o This will further worsen business confidence Causes of inflation Demand-pull inflation Occurs as a result of increasing AD in the economy

When the economy is near the full employment with a small amount of spare capacity in the economy o Increase in AD increase in average price level and real output When the economy is at the full employment level of income o Increase in AD cannot expand output to meet the increased demand the result is purely inflationary In each case, the increase in aggregate demand pulls up the average price level o This reasons for the increase in AD in either example could be due to changes in any of the components of AD. o E.g. there could be a high level of consumer confidence, causing consumers to increase consumption. o There could be a high level of demand for a countrys exports due to rising foreign incomes o The increase might be due to an increase in government spending.

Cost-push inflation Occurs as a result of an increase in the costs of production

An increase in costs results in a fall in short-run AS from SRAS1 to SRAS2 Increase in average price level and a fall in the level of real output Increases in the price level due to increase in the costs of labour may be referred to as wage-push inflation

Changes in the costs of domestic raw materials increase costs of production Increases in the costs of imported capital, components, or raw materials increase costs of production import-push inflation o Can be caused by fall in currency

Demand-pull and cost-push inflation Inflationary spiral If we assume hat the economy is near full employment, then the increase in AD results in an increase in demand-pull inflation as the price level rises from P1 to P2 (see demandpull inflation)

Higher price level rise in costs of production rise (including higher wages for workers due to high price level) (1) Shift in the short-run AS curve from SRAS1 to SRAS2 as a result of cost-push pressures (2) Higher wages may give households the illusion that they have more spending power increases in consumption shown as increases in AD2 to AD3 (3)

Inflation due to excess monetary growth Milton Friedman Monetarists (branch of neo-classical) Long-run AS curve is used to show this type of inflation

Increases in the money supply result in higher AD from AD1 to AD2. Because he economy rests at the full employment level of output in the long run, such increases in AD due to increases in the money supply are purely inflationary price level rising from P1 to P2

Reducing Inflation Demand-pull inflation o Due to excess AD therefore have to reduce AD (demandside) o Government could use deflationary fiscal policy (increase taxes and lower government spending) and/or deflationary monetary policy (raise interest rates and reduce the money supply) o Disadvantages Politically they are very unpopular (dont like higher taxes) Reduction in government spending less support for the government Higher interest rates harm those with a loan or mortgage o If a government wants to be re-elected they will be reluctant but in most countries the central banks carry out monetary policy In some countries (Australia and NZ) the central bank sets an explicit target rate of inflation The movement towards independence for central banks due to government tendency to pursue short-term political objectives resulted in high inflation Cost-push inflationary pressure o Targeting inflation results in a reduction in inflationary expectations o If people have faith in CB then they will not expect high inflation o Wont demand increases in wages higher than the expected rate of inflation ( cost of labour doesnt rise excessively) o Demand-side policies may bring down the price level result in lower national output and higher unemployment o Supply-side policies are more appropriate policies Difficult to distinguish the demand-pull from the cost-push factors therefore they use a mix of solutions. The more independent the central bank, the more likely that price stability will be maintained Monetary policy is the most effective way of managing AD through changes in interest rates o Difficult for governments to reduce their spending because of commitments to the public also takes a long time to take effect Monetarists (believe inflation is caused by excessive growth of money supply) money supply increase = real increase in national output

too much money chasing too few goods prices will rise to ration the output o But it is difficult to control the money supply in the economy
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How is inflation measured? Consumer price index (CPI) Statisticians choose a representative basket of consumer goods and measure how the price of this basket changes over time Price of the basket increases = average price level has risen List of the typical goods and services consumed by the average household, which are then grouped into categories Categories are given a weighting to reflect their importance in the average consumers income Prices of these items are measured each month by collecting prices from average shopping outlets Changes in CPI represent the headline inflation rate o Rate of inflation most commonly used Problems involved in the measurement of inflation: Represents the purchasing habits of a typical household not applicable to everyone o The purchasing habits vary greatly o Variations in regional rates of inflation within a country o If its for wage negotiations or pension changes Might not accurately reflect the price changes for a particular group harmful if the group has a higher cost of living than suggested by the national average unfair There may be errors in the collection of data that limit the accuracy o Impossible to collect prices of all items use sample households o The larger the sample, the more accurate the results Account for changes in consumption habits by making changes to the basket o Items are removed or added timely o If the items are changed limits the ability for comparison Hard to do international comparisons consumption patterns are different Prices may change for a variety of reasons that are not sustained o E.g. seasonal variations can be misleading o Reduce such distorting effects by excluding food and energy prices

CPI ignores other price changes that are important o Also measure changes in producer prices and commodity prices o These give economists a good idea of possible cost-push pressures